Calibration is a powerful technique that fits the relative valuation models to the benchmark securities market observed prices in order to value other securities, in a relative sense, to these benchmark securities. In particular, the method ensures the arbitrage-free interest rate model to be consistent with the observed market yield curve, the market volatility surface, and other benchmark securities’ prices to determine the basis spreads. The concept and the general methodology is applied to other markets beyond the interest rate markets and it is the key tool in developing hedging and arbitrage strategies, and pricing methodologies. The following chapters will apply this method to a broad range of markets and applications.
